John Carney Is An Insane Idiot On Insider Trading

We got a lot of heat today on our claim that the prosecution of Raj Rajaratnam is a waste of time.

Readers seem convinced that somehow ordinary investors are being hurt by insider trading. We just don't see it. So maybe you can help us out. In the comments section below, we invite you to propose ways that ordinary investors suffer actual losses because of insider trading. We'll promote the best answers to their very own post.

Keep in mind that we've already refuted quite a few of the arguments people tend to make in favor of criminalizing insider trading.

Buyers are hurt because insider trading buyers push up prices. That's true but diversified investors are as likely to be sellers as buyers in insider trades, so it ends up breaking even.

Sellers are induced to sell too low because they don't have the inside scoop. If anything, sellers are helped by insiders willing to buy their shares at the price the sellers are demanding. If the insiders are the only buyers at that price, then the seller would have been forced to sell at a lower price or hold a stock he wanted to sell.

Fewer investors will buy individual stocks if they are worried about insider trading. Ordinary investors tend to lose out when they try to pick stocks. They're actually benefitting if they avoid stock picking in favor of broad diversification and index funds.

Less money will come into stock markets if people are worried about insider trading. This probably isn't true. Insider trading leads to better pricing, which means that investors can be more confident in prices rather than less. Surprising quarterly results, for instance, will create less volatility in a market where insiders have been trading the stock.

Insider trading means that ordinary investors are disadvantaged when it comes to the pros. Unfortunately, this is the case regardless of insider trading regulations. People who are professionally dealing with stocks will always have a leg up on the investor who holds down a job and invests his money on the side.

Insider trading damages transparency and trust in the markets. Much of the trust that ordinary investors place in the fairness and transparency of the markets is misplaced. What's more, whatever costs may come from increased fears and investor caution are likely to be made up for by increased market efficiency.

I would never have sold if I'd known what the other guy knew. So what? This is a claim that you are entitled to all the information everyone else in the market has. But there's no justification for this claim. The market exists, in part, because different people have different kinds of information and different opinions about what that information means.

Insiders cheat outsiders when they trade on non-public information. Insiders almost never induce outsiders to sell. In a liquid market for securities, sellers typically have no contact with buyers. This means that they are selling without regard to who is buying or what information the buyer might have. No one is lying to anyone else because no one is explaining why they are buying or selling a stock. It's not like selling a car with a broken chasis and telling the buyer you just decided to walk more often.

Insider trading permits someone to talk down a stock while secretly buying it up in advance of good news. This might be possible but it is very hard to execute. In the first place, actual buying activity is more influential than rumors. More importantly, this is just stock manipulation which is illegal regardless of whether it is done through insider trading.

Based on the furious comments on our earlier posts, however, we assume some of you have much better arguments than the ones put forth above. So go ahead, show us why we're idiots on this subject.

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Personally, I think insider trading laws are part of a mass marketing ploy to get regular people to invest their money in stocks, particularly individual stocks. The average person shouldn't even consider buying stock, because they have no idea what they hell they are doing. Ask a typical investor to name the market cap of a company they own, what they think, it should be, and why. I have never gotten an intelligent answer from anyone who is not a finance professional, and yet people have significant chunks of their savings in these stocks. It's like signing up to buy a car just knowing the monthly payment, but not knowing whether it really costs $30K or $300k .

When it comes to stock picking, the game is massively rigged in favor of insiders, no matter what the law is on insider trading. The existence of the laws, and a few random prosecutions, are just an airbrush to make average people think they have a fair chance in the game. They don't, and we should stop pretending that they do. Only professionals and industry insiders should be buying individual stocks. In that case, the insider trading laws would have only very marginal impact, because only insiders and near-insiders would even be trading the stock.

Many of Carney's points are true. There are information asymetries that disadvantage retail investors. Buyers and sellers are unknown to each other, so it's difficult to say one induced the other to trade. And there certainly are a variety of feints and frauds in the market already.

But there are several points Carney slides in without any proof. The most important, and pernicious, of these is that insiders contribute to fair pricing. Really? In a stock like C, an insider could easily trade millions of shares without moving the stock more than a few basis points - or at all. Does that inform anyone?

Milton Friedman first argued against insider trading laws in the days when an "average" stock traded a few hundred shares and a most active traded a few tens of thousands. In those days, an insider taking a stake of even a thousand shares was much more apparent because volume was so thin. Today, where there are often hundreds of stocks trading a million or more shares a day, insiders can buy and sell without moving prices much, or at all.

Carney might argue if insiders don't, in fact, always move prices, and they can buy and sell without price impact in liquid names, isn't that a reason for making insider trading legal?

We'll leave aside the obvious point that if Carney makes this argument it amounts to a complete reversal of his earlier argument. Instead we'll talk about the risk to capital formation. It's not only retail investors who must believe the market is fair. Institutional investors must believe the market is fair too or they won't invest in equities. If the equities market is believed to be rigged, if insiders regularly profit on their undisclosed information, only insiders, or fools, will invest in equities. The equities markets will dry up and American companies will have a much harder time attracting capital.

Since we're having a completely normative (as opposed to empirical) discussion here, let me put up a completely normative proposition. Any gain in pricing efficiency from allowing insiders to trade is more than offset by the loss of efficient capital formation as investors leave a rigged market.

Do a thought experiment into a world where insiders are allowed to trade - they can trade on an FDA announcement, an earnings release, M&A activity, anything. Wealth managers and brokers will start offering "insider services" where they promise to work a position for an insider while minimizing price impact (so the tell doesn't leak into the market). These wealth managers will actively solicit insider clients with pitches describing how much money they made for this CEO and that CFO on this announcement or that deal. Business magazines and blogs will publish articles about how much money these insiders made ahead of the latest acquisition or drug announcement. And on and on. And this is good for the markets? This is what you want to see happen?